The economics of plenty - II

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June 16th, 2010 Rajiv Shastri

In my previous post, I argued for India discarding its existing economic policies formulated in times of shortages. India’s problems have changed and we now face a problem of plenty, especially when it comes to foreign exchange inflows.

Capital inflows, have outstripped our trade deficit over the last few years. However, India’s polices remain rooted in a time when capital inflows were miniscule and India was subject to a full blown balance of payments crisis.

In continuing with these policies, India is ignoring its changed position in the  world and its changed circumstances. It isn’t accounting for its strengths, overemphasizing its weaknesses, ignoring opportunities and losing sleep over threats.

India’s strength today is its population. After years of fearing India’s population problem, we are now in a beneficial demographic period. The rising middle class and its capacity to consume positions India firmly as one of the largest markets in the world.

So why does this not show in our GDP? We need to look no further than our currency. India’s weak currency policy has many repercussions and an understatement of our GDP in terms of other currencies is just one of them.

A weak currency makes all products more expensive for the domestic population. It is futile to say that it affects only imported goods. In an economy which imports most of its fuel, currency related inflation is all pervasive.

In addition, India’s domestic market for commodities is closely linked to international markets and a weak currency also causes domestic prices of locally  produced commodities to rise. If it weren’t so, most of India’s domestic commodities would be exported. These increased prices reduce the ability of our domestic population to consume, reducing domestic growth.

A weak currency also makes it more expensive for Indian companies to buy foreign companies. While this is not an end in itself, it is a means to a very important goal; the ownership of Intellectual Property. When Tata bought Corus and Jaguar-Land Rover, it didn’t just but their capacity to produce steel and cars. It bought the technology which allowed production of superior quality steel and cars. Profits follow technology. Tata Steel and Tata Motors will show that to be true. 

And there is no better example of this than Apple. The iPhone says its designed by Apple in California and assembled in China. Guess where the profits reside. India’s technological disadvantage can only be overcome by buying technology and then developing it further. If we start from scratch, by the time we reach where the world is today, the world would have moved on.

Looking at our conundrum from another angle, the capital needs of India’s infrastructure sector cannot be met domestically. We need global savings. Our policies should reflect our need to attract savings and the strength of our domestic market.
Our current policy framework, in contrast, is making a case for capital controls which will stop global savings from reaching us, to allow us to continue exporting goods and services to other markets. Infrastructure is key to ensuring that our rural population benefits from growth. In most parts of the country rural connectivity is atrocious.
Rather than taking our prosperity to our villages, we have succeeded in bringing our rural population to our cities. In a distorted understanding of urbanisation in growing economies, we believe it is normal for our cities to grow and our villages to shrink. We seem to ignore the possibility of basic urban comforts reaching the villages instead.

If we persist with our current policies, India will always remain an infrastructure-starved nation which can only dream of inclusive growth, not achieve it. And why are capital flows inferior to trade flows? Is it because the ones we focus on are those which can be reversed easily? FII flows can be reversed at the push of a button. So we design policies to allow only those flows which are subject to substantial market costs if reversed.

If we were to look beyond these, its easy to recognise the impact of our weak currency policy on long-term stable flows. Who will want to invest in a currency, or in assets denominated in a currency which is intentionally weakened by policy. Our currency policy increases targeted returns and reduces targeted time span. So rather than
incentivizing investors to start new companies in India, we are content with
allowing them to own our existing companies. A perversity, if the stated intention is to achieve growth, isn’t it?

Times have clearly changed and our minds have to keep pace. Its not India’s growth which is at risk. As mentioned in my earlier post, India will continue to grow regardless. But whether it’ll grow enough to satisfy the needs of a young nation will depend on what drives our policies. Fear or self-belief.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal
 

 
 
 
 

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5 Responses to “The economics of plenty - II”

  1. ravi Says:

    @Balakrishnan…..
    You sound to mean that Japan’s economy is very sound which is not, japan is under humongous debt and may faces sovereign default risk………….Japan is forced to accumulate foreign exchange(by holding U S treasury bonds) at the cost of domestic debt , which almost all countries do and is like paying a certain tribute to the chief of the tribe (U.S.) , the more tribute you pay the dearer you become to the chief………reasons for japan’s exports include a week yen, low costs and a favourable trade policy with U.S. In the short term managing the currency is the only option to manage exports……

  2. R Balakrishnan Says:

    I agree. Only when the rupee is strong, will India be an economic power. Look at Japan. 250 yen to the dollar a decade or so ago. If MITI was to just think about exporters, the country would have slid. Now at under 100 yen to the dollar, Japan exports much more. If an industry is so dependent on exchange rate for exports, it has no reason to exist. India has missed the bus in not allowing a manufacturing hub to be set up here, akin to China. But for the MoF and RBI, India would have been a rich country.
    Take the foreign exchange we have and build roads and airports. Take one city per five year plan and make it world class. Suspend frivolous PIL’s, empower the manager and see the change. And more important, have a punishment scale that is a true deterrent and not the wall street type. Yes, Rajiv, we have plenty of too many things, not all of them desirable, alas..

  3. Rajiv Shastri Says:

    @Arpit- The change in outlook is exactly what I am arguing for…

    @ravi- I’m sure you figured it out all by yourself and thats great, but “government has to borrow more” does not necessarily follow an increase in trade deficit. Neither does everything that follows after that. This is precisely the kind of alarmist policy mindset that keeps us on the path of currency depreciation keeping inflation high and interest rates higher. Look back at India’s economic history and you will see the havoc that this kind of thought process has wreaked on an unsuspecting population. I’m sorry, but you will have to pan that out more logically to actually raise an alarm.

  4. ravi Says:

    currency gets stronger-domestic buying power increases-demand for goods increase-imports rise(more than rise in domestic production)-trade deficit goes up-govt has to borrow more- interest rates for commercial activities go up-return on capital employed on businesses go down-foreign investment loses steam-currency devalued further and on and on - another greece……………………….

  5. Arpit Says:

    I wish i was as readily armed with stats & figures to be able to independently draw out such conclusions…it will be great if you could throw light on how india’s current policy on capital control has allowed it to be slightly isolated from the global turmoil…wouldn’t we be in a problem if we didn’t have a managed currency…plus i think its much easier for us to sit and comment on what can be done cause even if goes wrong max that will happen is few snippy comments highlighting how our view of flawed…but on the other hand policy makers would face much more severe consequences…anyways that can’t really be a reason to not take action but i think what needs to change is not really the policy alone…its the outlook! … we are soo easily satisfied with what we have that sometimes we lose sight of what we can….

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